Tackling the technicalities

After years of neglect Poland's new government now needs to push on with the reforms to its pension system which it began in 1999

Poland's new pensions system, which was introduced in 1999 and covers those born after 1948, is entirely based on individual accounts, of which there are two types. Of the 19.52% of a total salary that makes up a person's contribution to their pension, 12.22% goes to a non-financial defined contribution (NDC) account managed by the public social security institution (ZUS) where the rate of return is generated by the real economy. The remaining 7.3% goes to a financial defined contribution (FDC) account that is managed by private pension companies where the rate of return is generated by financial markets.

The system works by paying back what was paid in plus interest. In other words, the present value of benefits equals the present value of contributions. This leads to substantial macroeconomic effects. Pension expenditure as a share of GDP will decrease in the decades to come, from above 13% of GDP now to around 8% in 2050. This is in contrast to elsewhere in Europe where, according to European Commission projections, it will typically increase to 15-20% of GDP in 2050.

While at a macroeconomic level the new system works well, former governments did not develop the system's technical elements and years were wasted. Fortunately, the current government seems ready to move ahead.

There are several pressing issues:

A law on annuities that employs the efficiency of the market to serve the needs of social security in the payout phase; A law on co-ordinating disability pensions with the reformed old-age system; A law on bridging pensions, and Adjustments to regulations on pension fund investments.

A law on annuities

The key idea behind this is to ensure the achievement of the system's social goal. Without this legislation, mandating people to save while they are actively engaged in the workforce would not make sense. Previous governments have ignored the question of how to organise the payout phase. This government must resolve the issue swiftly because the first pensions will be paid from next year.

A ministry of labour and social affairs bill is currently before the cabinet. It must then be tabled in parliament, debated and passed, and approved by the president before it can be implemented.

The draft is not bad in terms of incorporating key ideas, but some details could be improved - and technicalities matter. What matters most is to have a good background for the law. The draft says there will be specialised insurance companies, called annuity companies. They will offer a limited list of products, just individual annuities; a phased-withdrawal option was rejected, keeping the system simple, easy-to-understand and cheap.

It also sets out temporary measures for those retiring next year while the special annuity companies are established and licensed. Their benefits will be paid out by the pension funds, with their account value divided by life expectancy to the age of 65, the age at which they must buy an annuity.

Annuity providers will be subject to domestic financial supervision but there will also be a need to create actuarial supervision. The government and we who support the reform process have examined many ideas based on UK practice. The process of actuarial supervision will be created by separate legislation.

Disability

Here we need to develop better family - that is survivor - benefits to ensure they are not financed out of old-age savings but as insurance. We must cap old-age-related disability benefits. Without an effective ceiling, disability benefits could in some cases be higher than old-age benefits.

Bridging pensions

This is a programme intended for a narrowly defined selection of workers who are unable to continue working until the regular retirement age. It will stand outside the universal pension system and be partly financed by employers. Implementation of the bridging pensions does not affect the universal retirement age.

Relaxation of investment rules

The key issue is the raising of the ceiling on foreign investments by pension companies. Today, the supervisory authority restricts foreign assets to a maximum of 5% of a portfolio. There are other regulations, including that foreign assets must be rated and that all costs associated with holding foreign assets must be paid by the management companies, not the fund as is the case with domestic assets. In effect the requirements act as a considerable disincentive to diversifying abroad.

The limit should be at least 30% but phased in over one-to-three years rather than overnight. In fact it is doubtful whether pension funds would use the whole limit, so it could even be put at 100%, as in Estonia and Lithuania.

In addition, allowance should be made for more equities in pension fund portfolios. Currently, they can go up to 40%. We need a higher allocation to equities but we also need to give the funds greater access to foreign equities otherwise we risk creating a bubble on our own stock exchange.

Critics argue that this introduces greater volatility into the portfolios and means that Polish money is being siphoned off abroad. Of course they could just rely on Polish government bonds, but that is similar to the way the ZUS runs the NDC accounts and the private funds are there to follow a separate strategy.

In a third step to assist diversification the regulator should broaden the pension funds' choice of assets. Some new instruments could be put on the list of accepted products.

And last, Poland's financial markets need to be developed through the supply of additional instruments. Currently, there is little to buy compared with the demand created by pension funds and other financial institutions. Corporate bonds are particularly needed.

The policymakers working on the problems need a clear understanding of the issues. The old-age system has been detached from the rest of the social security structure, so for instance the pension system and the disability system are separate and old-age contributions do not finance anything but old-age benefits.

But while the entire system is new the part managed by private firms remains part of the public system; the reform did not privatise the system it partially privatised management of the system.

The result is a kind of public-private partnership: private firms manage a part of the public system. That part of the old-age system that is managed by the ZUS is a ‘twin' of the part managed by the private institutions. And there have been suggestions that this approach could be extended to the ZUS, that its role could be privatised.

The special characteristics need to be fully understood when seeking the best methods to solve its remaining problems. Some ideas applicable in private pensions would be inefficient if applied to a public-private partnership.

Private means an individual decision whether to participate or not, also on the scale of participation, its form, when to turn the accumulation phase into the payout phase (maybe also a period of no accumulation and no payouts yet), and on institutional partners (asset managers). If the decisions were good we benefit, if they were bad we lose.

While in the public system (irrespective of whether it is publicly or privately managed) the decisions are taken for participants (some elements of choice may exist but they do not play a big role), the responsibility for outcomes is spread over the entire population. So, although similar from the point of view of managing companies, the privately managed part of the public system is quite different form the private-private additional programmes and they should not be confused with one another.

Marek Góra is a professor at the Warsaw School of Economics and one of the architects of Poland's pension reform